Audit Results

The State Board of Equalization Has Substantially Reduced Cigarette and Tobacco Products Tax Evasion With Methods Similar to Those of Other States

The methods used by the State Board of Equalization (board) to enforce compliance with excise tax laws for cigarettes and tobacco products have reduced significantly levels of tax evasion in the retail marketplace that were previously high. The board uses a three-part approach to enforcement: the board licenses all entities that sell cigarettes and tobacco products, it uses a digital signature in an encrypted tax stamp for packs of cigarettes, and it inspects retailers, distributors, and wholesalers that sell cigarettes and tobacco products. The board began using the encrypted tax stamp in 2005, and for fiscal year 2004–05 it reported that 869 inspections resulted in a seizure of cigarettes with counterfeit stamps. However, without altering the number of inspections, the number of instances in which inspectors found cigarettes with counterfeit stamps declined to 49 by fiscal year 2008–09, a 94 percent decrease—and it has remained low. Because the Cigarette and Tobacco Products Tax Program (tax program) and the Cigarette and Tobacco Products Licensing Program (licensing program) each help to enforce retailer compliance with tax laws, both programs are responsible for these improvements in retailer compliance. Finally, the board generally uses the same basic enforcement methods as two of the four other states we surveyed, although California is unique in its use of an encrypted tax stamp on cigarette packages.

In 2004 the board began licensing all entities involved in the sale of cigarette and tobacco products, including retailers, distributors, and wholesalers, and inspecting roughly 10,000 of these entities’ licensed locations each year as a part of implementing the Cigarette and Tobacco Products Licensing Act of 2003 (licensing act). Another law that took effect in 2005 required the board to add an encryption security feature to the cigarette tax stamp. In addition to serving as an enforcement mechanism, the tax stamp provides a means for the collection of tax payments for cigarettes in California; distributors pay the tax and affix a stamp to every pack of cigarettes they sell to wholesalers and retailers. Before 2004 the board was finding instances of retailers selling cigarette packages that lacked tax stamps, had tax stamps from other states, or had counterfeit stamps. However, after the board initiated annual inspections of roughly one-quarter of all licensed locations, of which 97 percent are retail locations, and required distributors to affix the encrypted tax stamp to cigarette packs, the board observed a significant and sustained decline in all forms of tax evasion. In fact, by fiscal year 2008–09 the number of inspections in which the board seized cigarettes that had counterfeit tax stamps had declined by 94 percent, as Figure 3 indicates.

Figure 3
Inspections That Result in a Seizure of Cigarettes That Lack a California Tax Stamp Have Declined Significantly

Sources: Investigations reports and other documents prepared by the State Board of Equalization.

The tax program and the licensing program are each responsible for at least one piece of the board’s approach to enforcing retailers’ compliance with the excise tax law. The tax program provides an encrypted tax stamp for all packs of cigarettes, and the licensing program administers the retailer licensing requirement and the inspections of retailers. On its own, the encrypted tax stamp would not effectively deter tax evasion by retailers because without inspections to enforce the sale of legal, tax-paid products, retailers could simply sell untaxed products with little fear of being caught. However, the combined enforcement powers provided by the licensing process, the encrypted stamp, and the inspections have yielded compliance improvements. A licensing requirement helps the board identify all retailers in the state legally allowed to sell cigarettes and tobacco products; security features in tax stamps protect the integrity of the cigarette tax stamp from counterfeiting; and inspections provide the means for checking whether retailers are attempting to sell cigarettes with counterfeit stamps, no stamps, or stamps from other states.

The Board Uses Enforcement Methods That Are Generally Similar to Those of Other States

The board uses generally the same enforcement methods as those of other states we surveyed; one difference being that the board adopted an encrypted tax stamp in 2005 to comply with a state law intended to address an increase in the counterfeiting of cigarette tax stamps in California. As Table 3 shows, California and two of the four other states we surveyed use the following three enforcement methods: a licensing requirement for retailers, a cigarette tax stamp, and inspections of retailers.

Table 3
Enforcement of Sellers’ Compliance with Taxes on Cigarette and Other Tobacco Products in California and Other States

Sources: Interviews by the California State Auditor’s Office with other states and its analysis of various sources.
* Average number of years between inspections. The average is derived using the total number of annual inspections and total number of entities inspected in the state. New York conducts inspections, but we were not given enough information to compute its frequency.† This range of years reflects uncertainty in the total number of retailers. Because Arizona does not license retailers, only estimates of the total number of retailers are available.

Arizona and Oregon differ from California in that they do not license the retailers involved in the sale of cigarettes and tobacco products. As also shown in Table 3, none of the other states that we reviewed use an encrypted tax stamp; instead, these states have opted for unencrypted tax stamps employing traditional features. In fact, few other states in the country use encryption technology, as Figure 4 indicates.

Figure 4
The Different Types of Stamps Used by States to Tax Cigarettes and Other Tobacco Products

A state law required the board to replace, by January 2005, California’s existing cigarette tax stamp with a stamp containing encrypted information. The author of this legislation intended for the stamp to address a dramatic increase in counterfeiting that the board had reported. In contrast, according to Arizona’s chief of investigations, Arizona has continued to use a traditional stamp partly because inspectors and investigators have not uncovered much counterfeiting. Similarly, the chief of investigations for Texas told us that he believes the incidence of counterfeit cigarette tax stamps in Texas is low. The two other states that we surveyed—New York and Oregon—cited the high costs of encryption and new equipment as reasons for continuing to use a traditional stamp on cigarette packs.

According to the board’s chief of investigations, the encrypted stamp improves upon the previous tax stamp because it allows inspectors to more efficiently and reliably validate the authenticity of California’s cigarette tax stamps and to identify counterfeit stamps during inspections. In addition, the chief of investigations stated that no one has successfully duplicated the encryption of the current tax stamp. The small number of counterfeit tax stamps that inspectors continue to find in retail stores are typically similar in appearance to authentic stamps, but inspectors can use their handheld scanners to determine immediately that the imitation stamps are counterfeit.

Although the Board May Fund the Licensing Program With Cigarette and Tobacco Products Taxes, It Has Accumulated an Excess Amount of Unspent License Fees

Although it is legally permissible to use cigarette and tobacco product taxes to fund the licensing program, the program’s Cigarette and Tobacco Products Compliance Fund (compliance fund), into which the board deposits the program’s license fees, fines, and penalties, has amassed a larger-than-necessary fund balance. This is particularly problematic because, under the current license fee structure, the licensing program does not generate enough revenue to cover all of its costs primarily because retailers, which make up 97 percent of the licensees, only pay a one-time license fee of $100. Nevertheless, there are options available to the Legislature to address this ongoing shortfall and make the licensing program self‑supporting. These options would also enable the taxes that are now being used to fund the licensing program to fund the programs they were primarily intended to sponsor.

The Board Uses Money from Propositions 99 and 10 to Support the Licensing Program

The licensing program uses several million dollars a year of cigarette and tobacco products taxes to help fund its licensing program. Since fiscal year 2006–07 the licensing program has not generated sufficient revenue to cover its costs, so revenue from cigarette and tobacco products taxes pays for most of the licensing program’s costs for inspections, licensing, and the program’s other functions. As Table A1 of the Appendix shows, the licensing program’s costs in fiscal year 2014–15 were more than $9.8 million. However, the program brought in only about $1.8 million from license fees and fines in that fiscal year, so the licensing program’s revenue fell short of covering its costs by roughly $8.0 million.

In 2006 the board received approval for a budget change proposal to make up for the licensing program’s funding shortfall by offsetting a portion of the revenue of the following four funds that receive revenue from taxes on cigarette and tobacco products: the Breast Cancer Fund, the Cigarette and Tobacco Products Surtax Fund, the California Children and Families Trust Fund, and the Cigarette Tax Fund. The board splits the shortfall among the four tax funds in proportion to how much cigarette tax revenue each receives. Two of the four cigarette and tobacco products tax funds—the two created by Propositions 99 and 10—covered 86 percent of the licensing program’s shortfall in fiscal year 2014–15, amounting to $6.8 million. Propositions 99 and 10 require revenue to be deposited into specific funds and used for particular purposes, except for refunds and reimbursement of the board’s expenses incurred in the administration and collection of these taxes. Although the licensing program itself does not directly collect taxes, its activities—including licensing, inspecting, auditing, and seizing of untaxed cigarettes and tobacco products—are integral functions of the administration and collection of these taxes. As a result, it is permissible to use money from these four funds to administer the licensing program. However, if other sources of revenue were used to fund the licensing program, the Legislature could increase the amount of funding that would go to programs funded by Propositions 99 and 10.

The Licensing Program’s Compliance Fund’s Excess Balance Could Be Used to Offset the Licensing Program’s Future Costs

The compliance fund has accumulated an excess fund balance that the board could use to offset the licensing program’s costs. According to the licensing act, all money collected—including license fees and license violation penalties and fines—must be deposited in the compliance fund, and it must be available only for the purpose of administering the licensing program. As of June 2015, the compliance fund had built a sizable fund balance, amounting to $8.9 million. According to the budget section manager, several factors contributed to the increase in the compliance fund’s balance, including underestimating revenue; budgeting expenditures at levels significantly lower than estimated revenue; experiencing a large, unexpected drop in the fund’s share of statewide apportioned costs; and, in fiscal year 2011–12, a special fund reconciliation by the Department of Finance that increased the fund balance by $2.8 million. Consequently, the balance steadily grew from $1.1 million in fiscal year 2006–07 to $8.9 million in fiscal year 2014–15. The budget manager noted that beginning in fiscal year 2014–15, the board planned to appropriate expenditures above estimated revenue until the fund balance is decreased to an appropriate level. In order to determine what might be a reasonable compliance fund balance, we consulted the guidelines published by the Government Finance Officers Association (GFOA). The GFOA’s mission is to enhance and promote the professional management of government entities by identifying, developing, and advancing fiscal strategies, policies, and best practices for the public benefit. According to GFOA’s guidelines, a reasonable fund balance for a general fund would be an amount equivalent to two months of operating expenditures, which in this case would be $1.6 million if the licensing program’s expenditures for fiscal year 2014–15 were used. The remaining amount, $7.3 million, would be considered an excess fund balance.

Number of Entities With Licenses to Sell Cigarette and Other Tobacco Products as of July 2015

Retailers—35,020

Distributors—523

Wholesalers—351

Manufacturers and Importers—121

Source: State Board of Equalization report titled Summary of Total Active Accounts by Location, July 1, 2015.

Options Exist to Eliminate the Licensing Program’s Funding Shortfall and Make the Program Self-Supporting

The Legislature has several options to address the licensing program’s ongoing shortfall, eliminate the excessive fund balance of the compliance fund, and maximize the funding for the programs, such as breast cancer research and early childhood development, that tobacco taxes support. The options we outline later include the board’s using one-fifth of the excess fund balance discussed in the last section over a five-year period to partially offset the license fee increase proposed in each alternative. Also, each option would support the licensing program with some money from one of the four tobacco tax funds, the Cigarette Tax Fund. All remaining money in the Cigarette Tax Fund would be transferred to the State’s General Fund. Support from the Cigarette Tax Fund would be fixed at the amount that the fund contributed to the licensing program in fiscal year 2014–15 for the first two options. None of the options would change or increase the manufacturers’ and importers’ one‑time license and administrative fees. These options assume program costs are stable and that the actual number of retailers, distributors, wholesalers, manufacturers, and importers remains the same, as the text box shows. However, if program costs increase or the number of businesses needing a cigarette and tobacco products license decreases, the Legislature may need to revisit the funding options.

Funding Options Would Have Increased the Tobacco Tax Revenue Available for Non‑Enforcement Programs in Fiscal Year 2014–15
(in Millions)

Revenue from cigarette taxes

$748.0

Revenue from other tobacco products

87.0

Total revenue

$835.0

Cigarette and Tobacco Products Tax Program cost

$(22.4)

Cigarette and Tobacco Products Licensing Program costs

(7.9)

Total tax and licensing program costs paid with cigarette and tobacco tax revenue

$(30.3)

Total revenue available for non-enforcement programs before licensing program funding options

$804.7

Total revenue recovered by this report’s
proposed funding options*

$7.0

Total revenue available after funding options

$811.7

Source: California State Auditor’s analysis of the State Board of Equalization’s accounting records.

* Under each funding option, $913,000 from the Cigarette Tax Fund, which is the amount the fund provided the licensing program in fiscal year 2014–15, would still go to fund the licensing program. We suggest continuing to use these cigarette taxes to fund the licensing program because the money would otherwise go to the State’s General Fund as opposed to a specific program. Therefore, the funding options would recover only $7.0 million of the $7.9 million of cigarette and tobacco taxes used to fund the licensing program in fiscal year 2014–15.

Currently, state law requires cigarette and tobacco products retailers to pay a one-time licensing fee of $100, distributors and wholesalers to pay an annual licensing fee of $1,000, and manufacturers and importers to pay both a one-time licensing fee of either $2,000 or $10,000, depending on the products that they sell, and an administrative fee based on their California market share of cigarettes and tobacco products. In 2004, the first year of the licensing program, the distributors’ and wholesalers’ annual fee, the retailers’ one-time license fees, and a one‑time administrative fee for manufacturers and importers generated sufficient revenue to cover the cost of the program when all retailers—about 45,000—paid this fee. However, since this initial period, only new retailers applying for a license to sell cigarettes and tobacco products—about 5,600 per year—pay the $100 fee. In fiscal year 2014–15 the total for this one‑time fee amounted to about $560,000. Even after combining this revenue with the $1.2 million from fines and fees from the other licensees, the total is significantly less than what is needed to fund the licensing program’s operations.

Under the first option, the retailer’s license fee would change from a one-time fee of $100 to an annual fee of $170 for five years, and then the fee would increase to $215 annually after the licensing program has used its excess fund balance. There would be no change to the distributors’ and wholesalers’ annual license fees. These fee changes and increases, combined with money from the compliance fund’s excess fund balance and from the offset to the Cigarette Tax Fund that otherwise would be transferred to the General Fund, would eliminate the need to pay for the licensing program’s costs by offsetting revenue from cigarette and tobacco products taxes that would otherwise go to the funds created by propositions 10 and 99 and the Breast Cancer Fund.

The second option would include a retailer license fee increase as well as an increase in the distributor and wholesaler license fee from $1,000 annually to $1,200 annually. As with option one, the retailer’s license fee under this option would be changed from a one-time fee to an annual fee. With an increase in the distributor and wholesaler license fee, the retailer fee increase would be less than the option one increase: an annual fee of $165 for five years, then increasing to $210 after the excess compliance fund balance is reduced. As shown in the text box, if one of the funding options in Table 4 had been in place in fiscal year 2014–15, the amount of cigarette and tobacco products taxes available for the programs they sponsor would have increased from $804.7 million to $811.7 million, a $7.0 million increase.

Table 4
Funding Options That Could Make the Cigarette and Tobacco Products Licensing Program Self-Supporting
(Dollars in Thousands)

Sources: California State Auditor’s analysis and accounting records of the State Board of Equalization (board).

* As of June 30, 2015, the compliance fund has an excess fund balance of $7.3 million. If the board used these excess funds equally over a five-year period to help fund the licensing program, it would amount to $1.46 million per year. As a result, some license fee increases would not fully occur for five years.† The board derived these amounts manually. The amounts listed are the board’s estimates for fiscal year 2014–15.‡ We derived this figure by multiplying the suggested fee by the number of licensees on July 1, 2015.§ The General Fund will continue to contribute the same amount of money to the licensing program as it did in fiscal year 2014–15 through the offset to the Cigarette Tax Fund.II This change doubles the current cigarette tax rate of $0.87 to $1.74 and applies the additional revenue to the four existing cigarette and tobacco tax funds at the same rate currently in place.# The funding options include one or more other revenue sources—compliance fund’s excess fund balance, license fee increases, and cigarette tax increases—to offset these funding sources, which totaled $7 million in fiscal year 2014–15.

The third option would add an increase in the cigarette tax as well as increases to retailer, distributor, and wholesaler license fees. Specifically, the cigarette tax rate would be increased 100 percent, from $0.87 to $1.74 on a pack of 20 cigarettes. However, because of the cigarette tax increase, this option would require a smaller retailer license fee increase of $140 annually for the first five years until the excess balance in the compliance fund is exhausted, then $180 annually thereafter. The distributor and wholesaler annual license fee would increase to $1,100 for five years and then go to $1,200 per year thereafter. Under this option, the State, licensees, and consumers would share the licensing program’s costs. Funds from these additional taxes would go to the four existing cigarette and tobacco products tax funds in the same proportion that the four are currently receiving in law and used for the same purposes. For example, Proposition 99’s tax would increase from 25 cents per pack of 20 cigarettes to 50 cents per pack, but its share of the total tax would stay at the same proportion, which is 29 percent of the new tax rate of $1.74 per pack of cigarettes. Also, the contribution to the licensing program from the General Fund via the offset to the Cigarette Tax Fund would double from the contribution amount of $913,000 in fiscal year 2014–15 to $1.8 million, and it would remain at this amount each year. As Figure 5 shows, California has one of the lowest cigarette tax rates in the nation, and its rate is also significantly below the tax rates of neighboring states of Arizona, Nevada, and Oregon. Further, doubling the cigarette tax would put California only slightly above the national average for taxes on a pack of cigarettes.

Although the Board’s Cost Allocation Methodology Is Reasonable, It Derived Some of Its Time Charges Incorrectly

If followed and if using accurate data, the board’s methods for identifying program costs and allocating them to each program, including the tax and licensing programs, would result in a fair and reasonable distribution of most costs. However, some of the entries in this cost allocation plan are based on incorrect time charges. Specifically, the special taxes division used a method that does not reflect actual staff time charges for its supervisor and support staff, and some investigations division staff used an outdated worksheet to derive their time charges. These methods resulted in inaccurate time charges, which have weakened the effectiveness of cost allocations that are based on these direct time charges.

Figure 5
As of October 2015 California’s Cigarette Tax Was Almost Fifty Percent Less Than the National Average

We selected and tested 10 operating expenses, five each from the tax and licensing programs, to determine whether the expenses were allocated reasonably. The policy and compliance division has an informal process in place to charge expenses to the applicable program, and we found that this process was reasonable. However, the board does not have an automated process that tracks, records, and allocates payroll costs on an individual level. Instead, the board allocates payroll costs as well as some operating expenses to programs based on time-reporting information using employee time as recorded in its Business Taxes Time Reporting system (time-reporting system). To test the time reported for the tax and licensing programs, we selected 20 payroll transactions, 10 from each program, and found that they all agreed with what was recorded in the time-reporting system. In addition, we interviewed each employee about his or her work activities and found that the employees’ descriptions of the work they performed aligned with the charges on their time sheets.

However, from the interviews we also learned that some staff charge their time according to a predetermined allocation, while others charge their time directly to the programs on which they are working. Of the 20 time sheets we tested, 10 were based on a predetermined allocation. These time sheets were for supervisors and support staff in the special taxes division. The board made adjustments to this allocation during the fiscal year to avoid exceeding budgets rather than to use the actual work that staff performed to make this allocation. Specifically, the special taxes division establishes an initial budget of the costs to charge to the largest of its 23 special tax programs, including the tax and licensing programs, then makes adjustments to the allocation to ensure staff’s time charges enable each program to stay within its initial budget. However, if the board’s special taxes division followed traditional cost accounting principles, it would adjust its initial allocation to match the actual amount of time its staff worked on each of the 23 programs. Overall, about 80 staff of the special taxes division’s 454 staff are supervisors and support staff who use the predetermined allocation to charge their time to the programs that the division administers. In fiscal year 2014–15 the board’s adjustments to the 80 staff members’ predetermined allocation for the tax program ranged from a reduction of 10 percent to an increase of 2 percent, depending on the unit within the division. As previously noted, these adjustments were not done to make the predetermined allocation match staffs’ actual time charges. Instead, according to the board, they were done to ensure each program was spending no more than the amount of money it was originally budgeted. We were unable to determine whether these adjustments caused the tax and licensing programs to be overcharged or undercharged their fair share of supervisor and support staff costs because total actual time charges were not available to compare against the adjustments.

The remaining 10 time sheets we tested belonged to staff who charge their time to the programs directly. However, one of these time sheets used a mechanism that automatically split an investigator’s time between the tax and licensing program when the employee worked on a cigarette and tobacco products tax case. Specifically, although the investigation division’s procedures instruct investigators to charge their time directly to the program being investigated, this investigator was using a discontinued time sheet template from 2005 that automatically distributes 42 percent of the investigator’s time to the licensing program and 58 percent to the tax program when the investigator works on a cigarette and tobacco products tax case. According to its assistant chief, the investigation division does not have a record of why or when it ceased using the 2005 time sheet template, but it was sometime before 2012, when he started working in the division. Also, the assistant chief was unaware that some investigators were continuing to use the discontinued template as a basis for charging their time. The assistant chief estimates that 20 of the division’s 40 investigators were using the discontinued 2005 time sheet template but that in fiscal year 2014–15 only three investigators—the person we selected in our testing and two others—charged time to cigarette and tobacco products tax investigations using the discontinued template. Going forward, the assistant chief indicated that he will work with the board’s budget unit to determine how staff that work on investigations that relate to cigarette and tobacco products taxes should allocate their time to the tax and licensing programs. However, until this determination is made, these staff will continue to use the outdated 2005 time sheet template.

The board could reduce its costs more than $360,000 by adjusting the annual number of inspections so that the frequency of inspections is the same as it was when the licensing program started. The frequency with which the board inspects each licensed location has increased over time because although the number of licensees has significantly declined, the board continued to perform about the same number of inspections. The licensing act authorizes the board to conduct inspections as part of its enforcement efforts, and the board’s initial plan for implementing the act called for periodic on-site inspections of all cigarette and tobacco retailers, distributors, and wholesalers in the State. The board proposed that it would inspect 10 percent of the 85,000 retailers that it estimated would be required to be licensed. Specifically, the board proposed conducting 10,625 inspections of retailers—8,500 initial inspections and 2,125 reinspections of retailers who had violations in the initial inspection—in fiscal year 2004–05 and established a goal of 10,000 inspections for every year thereafter. However, the board’s data show that the actual number of retailers applying for licenses in fiscal year 2004–05 was only about 45,000, and the number of licensed retailers further dropped the following fiscal year to 38,000 because a large number of retailers had mistakenly applied for a license in the act’s first year.

According to the branch administrator of the special taxes division, the board acknowledges that its initial estimate of the number of retailers in the State was not specific enough to accurately determine the cigarette and tobacco product retailer population. The licensing act also authorizes the board to inspect licensed cigarette and tobacco product distributors and wholesalers, which amounted to slightly more than 1,000 in June 2006. With a little more than 39,000 licensed retailers, distributors, and wholesalers as of June 2006 and a goal of 10,000 inspections per year, the frequency of inspection would be about 26 percent of the licenses per year. On average, the board has met its goal of conducting 10,000 inspections per year. However, the total number of locations licensed by retailers, distributors, and wholesalers has declined to 35,894 in June 2015, an 8 percent decrease since June 2006. According to the board, some of the decline is due to retail chain stores that have decided to stop selling cigarettes and tobacco products at many or all of their stores, citing health concerns as the impetus for their decision. Regardless of the reason, the decline in retailers as well as distributors and wholesalers has resulted in an increased frequency of inspections.

Because the number of licensees selling cigarettes and tobacco products has declined, the average percentage of licensees’ locations that the board inspects each year has increased from about 26 percent of the total locations in fiscal year 2005–06 to 28 percent in fiscal year 2014–15. Although the difference between these percentages seems minor, in fiscal year 2014–15 the board would have inspected over 800 fewer licensee locations than it did 10 years ago had the board kept the frequency of inspections at the rate of about 26 percent of licensee locations. We estimate that conducting over 800 fewer inspections each year would result in cost savings of more than $360,000 per year. According to the chief of the investigations division, the reason he has not proposed changing the number of inspections conducted each year is because the current number has worked well and has contributed to the significant positive outcomes of the three-part cigarette and tobacco products tax enforcement program, including reductions in cigarette and tobacco products tax evasion that the board’s economist estimated at $91 million in fiscal year 2012–13. Inspections in the early years do appear to have contributed to a marked decline in the evasion of cigarette excise taxes. As was previously shown in Figure 3, the annual number of inspections that resulted in a seizure of untaxed cigarettes has dropped dramatically since fiscal year 2004–05.

However, we do not believe the increase in the frequency of inspections that has occurred is necessary to maintain these positive results. Specifically, Figure 3 shows the large declines in seizures of untaxed cigarettes occurred at the beginning of the inspection program, but that since fiscal year 2008–09 seizures have remained low. Therefore, we believe the board could return to its initial frequency of inspections and continue to maintain the high level of compliance with the cigarette tax law that the three‑part enforcement program has already achieved.

Recommendations

To make the board’s licensing program self-supporting, the Legislature should consider passing legislation to implement a funding model that will include a license fee increase or a combination of license fee increases, continued use of money from the Cigarette Tax Fund, and a cigarette tax increase similar to one of the proposed options outlined in this report.

Unless the Legislature directs the board to eliminate the compliance fund’s excess fund balance within a time frame of more than a year, the board should eliminate the excess fund balance by June 30, 2017 by using it to offset the licensing program’s annual funding shortfall. The board should also limit the fund’s future balance to no more than two months’ worth of licensing program expenditures.

The special taxes division should amend its budgeting process to reflect actual work that supervisors and support staff perform instead of adjusting staff members’ predetermined allocations of time to ensure that the division does not exceed each program’s budget.

The investigations division should ensure that investigators charge their time according to division policy and should determine a method to more accurately allocate investigators’ time instead of using the predetermined method established in 2005 and since discontinued.

To reduce the licensing program’s enforcement cost without compromising the level of increased compliance with the cigarette and tobacco products tax law that the inspection program has produced, the board should reduce the number of annual inspections and reinspections of retailers, distributors, and wholesalers that it conducts each year to reflect changes in the number of licensees that sell cigarette and tobacco products in California. This adjustment should align with the same frequency of inspections that the board followed when it implemented the inspection program, which is 26 percent—or approximately one inspection every four years—of these licensed locations.

We conducted this audit under the authority vested in the California State Auditor by Section 8543 et seq. of the California Government Code and according to generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives specified in the Scope and Methodology section of the report. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.